Investing In China

Perhaps no investment opportunity has captured the minds of investors in recent years more than that of China. While the investment buzz surrounding China clearly includes some hype, the undeniable facts about China easily explain why China deserves all the attention it is getting. According to the World Bank, as of 2012, China held 1.3 billion of the world's 7.1 billion people. Almost 20 percent of the world's population resides in China. Where the excitement kicks in is the makeup of this 20 percent.

According to the National Bureau of Economic Statistics, in 2011 China's urban population exceeded its rural population for the first time in the country's history, at 690 million people versus 656 million, respectively. China's urbanization is what has single-handedly led to the country's impressive economic growth over the past couple of decades. And China continues to urbanize. It's taken three decades for China's population to be more urban than rural, and it's expected that China has another 20 years or more of urbanization ahead of it.

What's So Special About China and UrbanizationIn a word, urbanization equals growth and lots of it. As people shift from living an agrarian lifestyle to an urbanized one, a lot has to happen. Cities need to be built, which means growth in infrastructure, commerce and other services. Urbanization means economies shift from those where individuals transform themselves from self-sustainability to specialization. That specialization is the fuel capitalism needs to unleash its power. Specialization requires more education, and an educated society is typically a wealthier society. As per capita wealth improves, the quality of lives improve and humanity is better off. During this entire process, businesses sprout up, many of which offer tremendous wealth creation for shareholders.

If you think about the fact that China still has over 600 million people living a rural lifestyle, a majority of which are likely to become urbanized over the coming decades, the investment opportunity is huge. This group of 656 million people equals the population of two United States. Often one hears that China today (as of 2013) is what America was right before the industrial revolution. There are some fundamental differences between America then and China now (a democratic form of government vs. communism), but the essence of the comparison is accurate. Growth in the 21st century will belong to China, just as the 20th century belonged to the United States. That growth will create trillions of dollars in economic output in the coming years, so investors are wise to consider the investment opportunities in China.

Understand the Risk and RewardThe investment rewards in China will undoubtedly be huge, but to make the most of them, any intelligent investor should have a clear understanding of the risks involved. A detailed analysis of the China risk is well beyond the scope of this article, but understanding the basic layout provides a solid foundation. Also understand that risks should not deter investment - the U.S. was quite risky in 1900. Instead, risk should be understood so it can be properly accounted for.

First and foremost, understand that China is still a communist country. So despite all the free market principles that China has faithfully adopted, as a communist nation the rules that govern a public company in China are different than here in the U.S. Chinese stocks trade on the Shanghai Stock Exchange and the Hong Kong Stock Exchange. Both of these exchanges have similar listing requirements that you would see in U.S. stock exchanges. Companies have to report timely financial statements, have audits performed and meet other requirements of size and capitalization. Beyond that, the accounting rules differ, and that is where things can get murky.

A Mosaic of OptionsGiven the popularity of the China investment story, an abundance of investment products are readily available for investors eager to own a piece of this opportunity. As would be expected, some options are much better than others, and some options should be avoided altogether or left to the most sophisticated investors. That being said, investors today have various prudent ways to participate in the Asian miracle.

The best and perhaps safest way is to stick with what you know - U.S. companies that are doing a growing business in China. You get the best of both worlds here: the advantage of a U.S.-regulated, GAAP-adhering public company along with the profit growth potential coming from China. A great example of this has been Yum! Brands (NYSE:YUM), owner of the Pizza Hut, KFC and Taco Bell restaurant concepts. The Chinese are going gaga over these chains, and Yum! has been generating more and more profit thanks to China. Other names that fit this bill include Coca-Cola (NYSE:KO) and Apple (Nasdaq:AAPL).

Next up would be professionally managed funds that focus on China. Here you get professional investment firms, many of which have analysts and people on the ground in China, doing the legwork. The drawback can be huge fund expense ratios, and those need to be considered before deciding to jump in. If you want to invest directly in Chinese companies, focus on the blue chip companies in China. These companies are readily established, have deep financial operations, a bigger shareholder base and thus offer investors greater safety in a region still characterized by uncertainty.

Many Chinese companies are listed directly on the U.S. stock exchanges. Many years ago, these companies were market darlings. In recent years, however, virtually all of them have come under intense scrutiny due to the inability of investors to trust the financial statements. Unable to regain investor confidence, many U.S.-listed Chinese companies' share prices decreased significantly. Still, this category provides disciplined investors with an opportunity to find some attractive opportunities that are easier to research and trade.

The Bottom LineThere's no denying that China's economy will be the one to watch in the coming decades. Recently, China's economic growth has retreated some due to a cooling housing market and attempts to curb lending. The key, according to many economists, now resides with the Chinese consumer who still saves a big chunk of each paycheck. Even the Chinese government realizes this and is trying to promote consumption growth. Inevitably, China will have its hiccups as it proceeds to lead the global growth of the economy. But grow it will, and opportunities will surely be plentiful. Investors should consider the pitfalls, understand the risks and rewards, focus on shareholder-friendly companies and stick to investments they understand.